Many known traded stock index futures are often based on a price index representing the current price of the plurality of securities underlying the index. The computation of these known price indexes disregards dividends and any other income that the holder of the underlying securities collects. Accordingly, a futures contract based on a price index such as, for example, the S&P 500 index, the Dow Jones Industrial Average, or the NASDAQ-100 index, trades at a price that reflects an estimate of any intervening dividend or other income foregone by holding the futures contract instead of holding the underlying securities. Textbook discussions of (price) index futures pricing, for example, typically include a “fair value” formula that takes into consideration the prevailing interest rate as well as the estimated dividend between the trade date and the expiration of the futures contract. While the interest rate component is an observable variable, based only on information about the current credit market condition; the dividend component will only be realized over the course of the remainder of the life of the futures contract. As such, the dividend component is a random variable that represents a risk factor for the traders of price index futures.
Other known traded stock index futures such as the total return index are calculated to reflect the accrual of any dividend and other income from the underlying securities of the index as well as the reinvestment of the accrued dividend and income in the underlying securities. Futures contracts based on a total return index eliminate the dividends and income accrual as a source of risk.
Applying the price index and total return index methodology to the same portfolio of securities results in the two diverging time series of index value, owing to the compounding effect of the inclusion of dividend in the latter but not the former. As such, a futures contact based on, for example, a total return index associated with the S&P 500 index portfolio will have prices that are unrecognizable for followers of the predominantly reported index, the S&P 500 price index.